The past 10 years have been a truly terrible decade for U.K. pension funds.

Thanks to falling bond yields, collapsing share prices, and increasing life expectancy, pension funds have been under severe strain. As a result, the pension pots of millions of Brits saving for retirement have fallen steeply in value.

This problem has become even more acute for company schemes, partly due to accounting changes. Thanks to the guaranteed, final-salary pensions previously offered by most employers, many large companies have equally large "'legacy" pension shortfalls.

Indeed, according to the latest monthly report from the Pension Protection Fund (PPF), the combined total of U.K. pension deficits soared in May to an all-time high. As a result, this puts ever-greater pressure on pension sponsors (meaning employers) to make good these shortfalls over reasonable periods.

A 332 billion-pound black hole
Thanks to a sharp drop in gilt yields and plunging stock markets, the combined shortfalls of company pension funds in deficit spiraled upward to 332 billion pounds at the end of May, versus 246 billion pounds a month earlier. Thus, in a single month, this liability shot up by 86 billion pounds, which is a leap of more than a third (35%).

Even worse, this figure was below 94 billion pounds at the end of May 2011, so company liabilities are 3.5 times what they were a year ago, thanks to an increase of 250% in 12 months.

In total, the PPF calculates that there were 5,503 final-salary schemes in deficit at the end of May, from a total of 6,432. This means that around six in seven company pensions (86%) have liabilities greater than their total assets.

At the other end of the scale, the PPF identified 929 schemes in surplus at the end of May, down from 1,204 in April and 2,268 at the end of May 2011. In total, these schemes had a combined surplus of almost 20 billion pounds, down from 29 billion pounds at the end of April and 69 billion pounds at the end of May 2011.

Pension pressure
Then again, is this 332 billion-pound shortfall across more than 5,500 final-salary schemes such a big deal for investors? After all, pension promises are very long-term liabilities and, therefore, this particular time bomb has a fuse stretching decades into the future.

Also, the National Association of Pension Funds (NAPF) blames the Bank of England's quantitative easing ("money printing") for pushing up bond prices and therefore depressing gilt yields for pension funds and other bondholders.

Alas, pensions deficits should be of great concern to private investors, not least because -- at one level -- they are hard, real liabilities. Just because pension deficits move up and down sharply in response to falling and rising gilt yields doesn't mean that shareholders can simply ignore them completely.

What's more, in a queue of creditors, pension funds are firmly in front of shareholders. Thus, when a good business is brought down by a bad pension scheme, then shareholders lose everything before pensioners forfeit even a single penny. In other cases, dividends could be slashed or canceled in order to reduce pension deficits.

Held hostage by zombie pensions
Of course, pension trustees cannot ignore pension deficits. Instead, they must agree on a medium-term plan to reduce any deficit with the scheme's sponsor, usually over a decade. As a result, British businesses have been forced to divert profits away from shareholder dividends and capital investment and direct some free cash toward paying off deep pension deficits.

What's worse is that the recent all-time lows hit by gilt yields may have wiped out the big cash injections that many big businesses -- notably BT Group (NYSE: BT) -- have poured into their pension schemes in the past three years. Blame the eurozone crisis!

With higher pension contributions causing a drain on companies' free cash flows, investors need to be aware of the scale of pension deficits within their own portfolios. Worryingly, around one in 10 British companies (mostly small-cap firms) have pension shortfalls greater than their market values, according to JLT Pension Capital Strategies.

Pension albatrosses
Take a look at the following table, which shows the 15 FTSE 350 companies with the largest pension deficits by value at the end of 2011:

FTSE 350 firm

Deficit (billion pounds)

Funding Level

Market Value (billion pounds)

Deficit (%)

Royal Dutch Shell (NYSE: RDS-B) 1.68 96% 134.6 1%
GlaxoSmithKline (NYSE: GSK) 1.22 91% 73.3 2%
HSBC Holdings 1.83 91% 99.1 2%
Unilever 1.22 92% 59.1 2%
Imperial Tobacco 0.75 79% 23.7 3%
BP 2.94 88% 79.3 4%
AstraZeneca 1.58 75% 34.1 5%
Rio Tinto 2.10 80% 40.4 5%
Tesco 1.36 81% 24.5 6%
Barclays 2.74 87% 23.6 12%
BT Group 1.83 95% 15.8 12%
Royal Bank of Scotland (NYSE: RBS) 2.18 91% 13.7 16%
British Airways 0.83 95% 2.7 31%
BAE Systems (LSE: BA.L) 3.82 82% 9.0 42%
TUI Travel 0.80 61% 1.8 45%

Source: JLT Pension Capital Strategies, 12/31/11; current market values from Digital Look.

I've sorted these 15 members of the FTSE 100 (UKX) and FTSE 250 using the final column. This shows the ratio of their pension deficits (as at end-2011) to their current market values.

Thus, while oil giant Royal Dutch Shell had a near-1.7 billion-pound pension deficit at the end of last year (now sure to be much, much higher), this is a mere 1% of its 135 billion-pound market cap. Likewise, FTSE 100 stalwarts such as GSK, HSBC, and Unilever all have large absolute pension deficits that are minuscule when set against their massive market caps.

However, at the other end of this scale are "pension albatrosses" such as TUI Travel (45% deficit-to-market-cap ratio), BAE (42%), BA (31%), and RBS (16%).

Clearly, investors must take these relatively large pension deficits into account when weighing the merits of these companies. Otherwise, when money is siphoned off to reduce deficits, investors will be disappointed by future profits, cash flow, and dividends!

By the way, do you know which FTSE 100 firm investment genius Warren Buffett -- the world's third-richest man, with a $44 billion fortune -- has been gleefully buying into in 2012? To find out which U.K. brand the Oracle of Omaha is backing, simply download your free copy of our latest report, The British Business That Warren Buffett Loves.

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